IMF: global economy faces a 'threatening downward spiral'

The International Monetary Fund has called on the US and Europe to abandon
fiscal austerity and switch to stimulus measures, warning that the global
economy faces a "threatening downward spiral".

The comments come at the start of a dramatic week for the eurozone as Italy prepares to roll over record sums of debt and Germany's constitutional court (left) issues its long-awaited verdict on the legality of the EU's bail-out machinery.

Christine Lagarde, the IMF's managing-director, said the outlook had darkened suddenly over the summer.

"There has been a clear crisis of confidence that has seriously aggravated the situation. Measures need to be taken to ensure that this vicious circle is broken," she said.

"The spectrum of policies available is narrower because a lot of ammunition was used in 2009. But if governments, institutions and central banks work together, we'll avoid recession,"she told Der Spiegel.

The comments come at the start of a dramatic week for the eurozone as Italy prepares to roll over record sums of debt and Germany's constitutional court issues its long-awaited verdict on the legality of the EU's bail-out machinery.

Markets are already tense after the EU-IMF 'Troika' withdrew abruptly from Athens on Friday, accusing the Greek government of failing to comply with rescue terms.

The Italian treasury must redeem €14.6bn of debts this week and €62bn by the end of September, the most ever in a single month.

"We are experiencing very demanding times," Jean-Claude Trichet, the European Central Bank's president, said over the weekend. The ECB has stabilised Italy's debt over the last four weeks, capping yields on 10-year bond yields near 5pc through purchases on the secondary market.

It is unclear how much longer the ECB can keep doing this after a string of top officials in Germany described the bank's actions as illegal.

"The ECB cannot substitute for governments," said Mr Trichet. He was speaking at the Ambrosetti Workshop at Lake Como, where he held a closed-door meeting to discuss the euro crisis with Bank of England Governor Sir Mervyn King.

The ECB has bought an estimated €35bn of Italian debt under an implicit accord that Rome will deliver on austerity promises.

Premier Silvio Berlusconi has come close to breaching the terms by backsliding on a wealth tax and pension reform.

Emma Marcegaglia, head of Italy's Confindustria business lobby, said the austerity measures were "unjust, iniquitous, and inadequate", and undermine the credibility of the country.

Leading Italian economists have begun to question whether EMU itself is workable.

"It's clear that the euro has virtually failed over the last ten years, even if you are not supposed to say that. We pretended to be Germans, but it was an illusion," said Professor Giacomo Vaciago from Milan's Catholic University.

Mrs Lagarde said the US has scope to "abandon short-term austerity and introduce some measures to drive growth" provided the country lays out a credible debt strategy over the medium term.

She said Europe needs to take its foot off the fiscal brake and shift to "growth-intensive measures" until the danger has passed, insisting that Germany has leeway to "stimulate demand".

The comments are certain to cause fury in Berlin, where the IMF is viewed as an agent of Keynesians and French mischief. Mrs Lagarde was French finance minister until two months ago.

Separately, Germany's constitutional court is expected to rule on Wednesday that Berlin's participation in EU bail-outs is allowable so long as the Bundestag is given a veto over future payments. However, there is an outside risk that it will go further, concluding that the nexus of rescue policies subvert EU Treaty law and German fiscal sovereignty and must therefore be curbed. This would amount to a "sudden stop" for EMU debt markets.

The judges are aware of these risks, yet they ruled two years on the Lisbon Treaty that German democracy is "inviolable" and that Berlin is duty bound "to refuse further participation in the European Union" if the constitutional order is threatened.

German patience with Athens is already near exhaustion. Prince Hermann Otto zu Solms-Hohensolms-Lich, the Bundestag's deputy president, said Greece cannot bring its debts under control.

"We must consider whether it would not be better for the currency union and for Greece itself to go for debt restructuring and an exit from the euro," he told the Frankfurter Allgemeine.